Depending on what you are trying to achieve will determine which valuation is important. Appraisal is more art than science.
Ken Kramer is the Co-founder and Managing Director at Rushton Atlantic, LLC. Rushton provides third party appraisals, valuations, for its clients; banks, insurance companies, governments, and property owners.
Three Different Appraisal Valuation Approaches
Income: based on the income the asset can produce over the life left in the asset.
As an investor, your primary interest is the income the property can produce. Can the property generate enough income to cover its operating expenses, reserve for capital expenditures, make the mortgage payment, resulting in a profit for you?
You are likely be interested in the market value as well. Are you getting a good deal? Can you sell it for more than you paid?
Fair Market/ Market: the value agreed upon by a willing buyer and seller in a particular market.
A bank views the property from a market value. Market value of commercial real estate is a function of net operating income. The NOI divided by the local capitalization rate (cap rate) will provide a market value.
The difference between the market value and the mortgage is lender’s margin of safety. If you fail to make the mortgage payments, the lender will take the property back through foreclosure. When this happens, the bank wants to be able to sell the property quickly, which is likely at a discount near the mortgage balance.
Cost/ Replacement Cost Approach: This method considers how much will it cost to replace or rebuild the property, building, with a new building.
The insurance company needs to know the replacement cost. The bank will require that you purchase insurance on the property to protect you and the bank from loss.
The best insurance coverage will provide replacement cost coverage to protect your asset. To determine the amount paid, the insurance company will compare the policy limit to the amount needed to repair the damage. The policy will pay up to the policy limits, provided your policy limit is within the limit conditions on the policy.
Different User Different Concerns
As you can see, different parties have different valuation considerations.
The buyer, wants to know income value, and the market value.
The bank wants to know the market value.
The insurance company wants to know the replacement cost value.
As Ken shared, “appraisal is an art form.” Values can move from year to year and Market Value does not equal Replacement Cost.
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